Ad behemoth WPP, which is making a variety of harsh allegations in a lawsuit filed about two weeks ago, is saying it is still not too big to be snookered by the start-up’s top execs and some of its other investors.

WPP (WPPGY), which has been quite active in making digital ad investments over the last several years, is alleging that Spot Runner sold over $54 million in “secondary” shares to line its own pockets without telling WPP much, all while losing money, running out of funding and not building a sustainable business.

The lawsuit essentially paints an ugly picture of Spot Runner as the Bernie Madoff of Web 2.0.

In its strongest phrasing, the lawsuit alleges:

“Rather than working to make Spot Runner a successful and profitable venture, they perpetuated a ‘pump-and dump’ scheme in which they aggressively promoted the Company to new investors (often by promoting that WPP was an investor in and supported of the Company) and then sold new investors large quantities of their own secondary shares at ever-increasing valuations. Such secondary sales were accomplished surreptitiously and without disclosures to Investors required by the controlling Investor agreements or federal and state securities laws.”

Those named in the suit include: Spot Runner CEO and co-founder Nick Grouf, CTO and co-founder David Waxman, venture investors Battery Ventures and Index Ventures, and board members, such as former AOL exec Robert Pittman.

This is obviously a bad turn of events for Spot Runner, which is currently reeling from the advertising downturn too.

All that money had, when times were good, given Spot Runner an eye-popping valuation upward of $500 million.

And that’s the very kind of bubble economics that apparently allowed some at the company to make those lucrative secondary sales the lawsuit alleges, with lots of demand to get in to the latest hot start-up.

To be clear, such sales are not uncommon at tech start-ups in Silicon Valley, often done to allow entrepreneurs to take some money off the table, especially if there is no clear path to liquidation.

But the scope of the sales alleged is quite unusual, with Grouf getting half the proceeds of the transactions, which were made from early 2006 to early 2008.

That said, WPP–which is seeking $11.5 million in damages, as well as legal fees, after investing $10 million–leaves itself open to its own tsk-tsking, since it finally got to participate some in the sales too, dumping $900,000 worth of shares in the last one.

That makes it seem like WPP is just miffed that it did not get enough while the getting was good, which is underscored by the small amount of money being asked for in the lawsuit, in comparison to the large and loud accusations.

Worse still, perhaps, for everyone involved, is the suit’s revelation that Spot Runner was not the revenue geyser it had touted itself as being–which should not come as a huge shock to anyone who has followed any Web 2.0 company in an even cursory way.

Very few, including the star, Facebook, make money, as BoomTown and others have pointed out a lot to little interest.

The lawsuit says the profit-free Spot Runner had $5 million in revenue in 2007 and $9 million in 2008. It alleges too that the company only has $20 million left of its funding and is spending $35 million to $45 million a year.

That’s because Spot Runner was trying to create a new online ad system, which was essentially a do-it-yourself model that tries to iron out inefficiencies in the buying and selling of advertising and bridge the gap between the traditional and online ad markets. It has since changed its strategy and is working on other products, such as a digital-media buying platform called Project Malibu.

Other than Spot Runner’s statement that it would defend itself vigorously, there were mostly no comments all around.

“This situation is unfortunate; we had hoped that we would have had a long relationship with WPP. We believe the claims are without merit and we will vigorously defend against them, including taking all necessary legal action to protect Spot Runner’s reputation,” said a Spot Runner spokeswoman in a statement.

But one source close to the Spot Runner side, while not addressing the specific allegations, noted in an interview with me that what looks bad now did not then:

This video took place right after a lot of the transactions that the lawsuit alleges, which makes sense since Spot Runner was the hot start-up at that moment and many would have been trying to get into the action.

I met Grouf many years ago when he–along with Waxman–founded PeoplePC and Firefly Networks.

Grouf sold the struggling PeoplePC–which hawked computers bundled with an online service–to Earthlink (ELNK) in 2002 for $10 million and assumption of $35 million in liabilities, in a Web 1.0 meltdown deal that followed a disastrous IPO.

But with a hot new start-up, everything looked pretty again, perhaps too pretty, for Grouf.

As I wrote at the time about the hype, which including rumors of Spot Runner being sold for big bucks to Google (GOOG) or Microsoft (MSFT):

“This is its biggest burden, I think, setting expectations very high for what is still a little start-up…Who knows whether the company will be able to overcome its hype, but time (and money) will tell.”

Obviously, we can tell a lot more now.

Here’s the Grouf video (the full lawsuit text and a memo Spot Runner sent to employees about it are also below):

And, finally, here is the letter Spot Runner sent to employees, who have suffered from layoffs, about the lawsuit:

Team,

As you may have heard, WPP, a minority shareholder (less than 3%) in Spot Runner since 2006, filed a lawsuit against the company and its board members primarily related to the sale of Spot Runner stock and Spot Runner’s communications with WPP. This situation is unfortunate, as we appreciate and value the relationships we have with all of our investors and we had hoped for a long and supportive relationship with WPP. We believe these claims are without merit and we will vigorously defend against them, including taking all necessary legal action to protect Spot Runner’s reputation.

We feel strongly that WPP’s complaint contains many baseless accusations and we want to give you a broader perspective on the matter. This lawsuit is unrelated to our products and services–it is centered on legal agreements entered into with WPP, a sophisticated investor, regarding the way that shareholder stock sales were handled. WPP alleges that Spot Runner’s board members failed to disclose to WPP the stock sales by shareholders, allegedly in violation of the board’s obligations to stockholders, among other things.

We are confident that Spot Runner complied with all of its obligations under the various shareholder agreements. When these sales occurred, there was overwhelming demand for Spot Runner stock and the company did not want to dilute existing shareholders by issuing new shares. Therefore, the founders (in 2006) and the board members and other preferred shareholders (in 2007 and early 2008) agreed to make room for important, new investors and respond to their desire to invest in Spot Runner by selling their own shares. In 2007 and 2008, WPP and other preferred shareholders were given notice that the sales were occurring and they had the opportunity to participate in the sales. In fact, WPP signed various documents acknowledging this opportunity.

Spot Runner and all of its employees conduct business with the utmost integrity. Our team, technologies, and products and services are core assets of which we can all be proud. It is because of your hard work that we have come this far. To that end, we continue to drive hard toward successfully launching Project Malibu and realizing its full potential. You also should know that our board members remain majority shareholders in Spot Runner–a concrete sign of their commitment to and confidence in the business.

Our outside counsel will work with the board and management team to develop a formal reply, which ultimately will be filed with the court. These legal proceedings should not affect our day-to-day operations.

We are grateful that we can count on you to remain focused on serving our clients and partners to the best of your abilities.

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